Amid Rumors and Stock Price Turbulence, ArthroCare Explores Options

Early this month, the board of directors at ArthroCare Corp. (Austin, TX) announced that the company has decided to investigate financial and strategic alternatives that could enhance its shareholder value. Possible alternatives include everything from a recapitalization or stock repurchase to the sale of certain assets or a potential merger.

The announcement comes on the tail of a tough few months for the company. Amid rumors of alleged inappropriate reimbursement practices, the company's stock has taken a significant hit over the past four months. At press time, the company reported a 52-week high share price of $65.70, significantly contrasted by its more-recent price of $32.75.

Prior to the company's announcement regarding the exploration of strategic alternatives, ArthoCare share prices had been taking quite a beating. “Since they surfaced in early November 2007, rumors propagated around the plasma disk decompression procedure and alleged inappropriate reimbursement practices have dogged [ArthroCare] shares, leading to a 38% stock decline,” says David Lebowitz, vice president of equity research for healthcare and medical devices at Sanders Morris Harris (Houston).

After the announcement, ArthroCare stock jumped 7% to close at $43 per share. At press time, however, the stock was still hovering around $34 per share.

“We remain confident in the strength and growth opportunities of our business, as reflected in our reported 2007 results and the guidance previously provided for 2008 in our recent earnings call, as well as the opportunities for near- and long-term value creation for our shareholders through execution of our business plan,” says Michael Baker, CEO of ArthroCare. “Any decisions the board makes will be based upon what it believes will be best for enhancing shareholder value.”

ArthroCare has been viewed as a potential acquisition candidate ever since the 2007 acquisition of Kyphon Inc. (Sunnyvale, CA) by Medtronic Inc. (Minneapolis), which represented a $4.2 billion consolidation in the spine market, says Lebowitz. “The company's Coblation technology—which contributes a substantial portion of revenue across each of the businesses (sports medicine, ENT, and spine)—could be attractive to a variety of potential acquirers,” he says. “Coblation's versatility would seem to make highly diversified medical device players the most likely candidates. These companies could easily expand the use of the technology beyond its current areas.

“Considering the rumors surrounding the stock, it might be some time before any substantial M&A activity takes place,” Lebowitz adds. “Any potential acquirer would be careful to conduct full due diligence on the reimbursement issue.”

Earlier this year, ArthroCare announced its $25 million acquisition of DiscoCare (Margate, FL), which the company described as a third-party billing and reimbursement service provider. Specifically, at the time of the acquisition, DiscoCare provided reimbursement assistance to physicians using ArthroCare's plasma disk decompression device. The company reported that the acquisition would enable it to significantly expand its internal reimbursement capability and to leverage such services across all divisions.

The move surprised some industry observers, as it came on the heels of insinuations from some analysts and media outlets that the relationship between the two companies might cross the line of acceptable business practices. Although the company refuted such reports, many analysts expected ArthroCare would still attempt to distance itself from DiscoCare.

“As an organization, we have a well-earned reputation for integrity and ethical behavior which we take very seriously,” Baker stated in December 2007. His statements were made in response to allegations printed in the New York Post, which suggested that DiscoCare might have engaged in inappropriate business practices. The article has since been retracted.

“Our FDA-cleared plasma disk decompression products are globally recognized as being among the most clinically successful and cost-effective spinal therapies,” Baker added. “We have carefully reviewed the business practices of our service provider and have found no evidence of anything improper in their activities. In fact, we believe that the application of a disciplined diagnostic and treatment algorithm improves patient selection and outcomes, and that the involvement of experienced professionals in the reimbursement process significantly decreases the chance of administrative errors.”

Despite Baker's comments and the article's retraction, speculation surrounding ArthroCare's reimbursement practices has persisted. On March 25, however, the company reported that it had been notified by the Nasdaq stock exchange that its review of DiscoCare had been closed. Details about the scope or focus of Nasdaq's investigation were not disclosed.

In addition to the continued controversy, there are several other risks that could negatively affect the outcome of ArthroCare's strategic alternative explorations, Lebowitz says. “First, while plasma disk decompression has had strong clinical results—data point toward an 80% reduction in pain—obtaining reimbursement has not been easy,” he says. “Many payers in the United States have yet to remove the ‘experimental' label despite approval by FDA. The reimbursement situation is improving, but is still being mostly addressed on a case-by-case basis.”

In addition, Lebowitz notes that ArthroCare is highly leveraged toward the continued adoption of the Coblation procedure. “Although the company competes in multiple unique markets, Coblation accounts for the bulk of revenue,” he says. “If physicians do not adopt at expected levels, the stock's valuation will suffer.”

The ArthroCare board has retained Goldman Sachs & Co. to assist it in the evaluation of its alternatives.

About a week after ArthroCare announced its hiring of Goldman Sachs, class action law firm Schatz Nobel Izard PC (Hartford, CT) announced that it is investigating possible securities law violations by ArthroCare. The investigation concerns whether ArthroCare materially overstated its financial results through the improper recognition of revenue. Specifically, the investigation concerns whether ArthroCare improperly recognized revenue from its business relationships with DiscoCare and another firm, Device Reimbursement Services.

Whatever the long-range future may hold for ArthroCare, industry watchers will likely be hearing a lot more from and about the company in the short-term. Stay tuned.

© 2008 Canon Communications LLC

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